On July 23, 2015, the Internal Revenue Service (IRS) issued long-awaited proposed regulations discussing the taxation of management fee arrangements commonly used by private equity funds and their management. The proposed regulations address the tax treatment of disguised payments for services under Section 707(a)(2)(A) of the Internal Revenue Code (the Code) where a partner has rendered services to a partnership in a capacity as other than a partner. By specifically classifying certain fee arrangements, including particular carried interest mechanisms, as disguised payments for services, the proposed regulations target purportedly abusive situations where private equity funds use management fee waivers to convert services income, taxable at the ordinary rates, into income items meriting capital gain treatment.

The proposed regulations provide that an arrangement will be treated as a disguised payment for services, instead of an allocation of partnership income, if, at the time the parties enter into or modify the arrangement, (i) the service provider, either in its capacity as a partner or in anticipation of becoming a partner, performs services, directly or indirectly through a delegate, to or for the benefit of the partnership, (ii) there is a related direct or indirect allocation and distribution to the service provider, and (iii) when viewed together, the performance of services and the allocation and distribution are ‘properly characterized’ as a transaction occurring between a partnership and a person acting other than in that person’s capacity as a partner. Once an arrangement is treated as a disguised payment for services under the proposed regulations, the arrangement is treated as a payment for services for all other purposes of the Code. Under the proposed regulations, the question of whether an arrangement constitutes a disguised payment for services depends on all of the facts and circumstances. However, the proposed regulations specify six non-exclusive factors that may indicate that an arrangement is a disguised payment for services:

The arrangement lacks significant entrepreneurial risk.

The service provider holds, or is expected to hold, a transitory partnership interest or a partnership interest for only a short duration.

The service provider receives an allocation and distribution in a time frame comparable to the time frame that a non-partner service provider would typically receive payment.

The service provider became a partner primarily to obtain tax benefits that would not have been available if the services were rendered to the partnership in a third party capacity.

The value of the service provider’s interest in general and continuing partnership profits is small in relation to the allocation and distribution.

The arrangement provides for different allocations or distributions with respect to different services received, the services are provided by related persons (as determined under the Code), and the terms of the differing allocations or distributions are subject to levels of entrepreneurial risk that vary significantly.

Of these six factors, the first factor regarding significant entrepreneurial risk is the most important and often will be determinative. The presence or absence of significant entrepreneurial risk is based on the service provider’s entrepreneurial risk relative to the overall entrepreneurial risk of the partnership. The proposed regulations identify five arrangements that presumptively lack significant entrepreneurial risk: (i) capped allocations of partnership income if the cap would reasonably be expected to apply in most years; (ii) allocations for a fixed number of years under which the service provider’s distributive share of income is reasonably certain; (iii) allocations of gross income; (iv) an allocation (under a formula or otherwise) that is predominately fixed in amount, is reasonably determinable under the circumstances, or is designed to assure that net profits are highly likely to be available to make an allocation to the service provider; and (v) arrangements in which the service provider waives its right to receive payment for the future performance of services in a non-binding or untimely manner.

The proposed regulations conclude by applying these factors to a set of management fee arrangements in a series of examples. The provided examples examine the impact of certain management fee features, including clawback provisions, control over allocations and distributions by a related party and the timing of fee waivers, on the taxation of the arrangements as disguised payments for services.

Safe harbour modification

In the preamble to the proposed regulations, the IRS also announced related changes to Rev. Proc. 93-27 concerning the issuance of ’profits interests’ (also known as ‘carried interests’) to service providers. This Revenue Procedure contains a safe harbour for holders of carried interests to be treated as partners and achieve capital gain treatment on certain partnership gain allocations. The IRS plans to modify the Revenue Procedure to include an additional exception for ‘profits interests’ issued in connection with a partner forgoing payment of a substantially fixed amount (including a substantially fixed amount determined by a formula, such as a fee based on a percentage of partner capital commitments) for the performance of services, including a guaranteed payment or a payment in a non-partner capacity. The IRS also stated that Rev. Proc. 93-27 does not apply to transactions in which one party provides services and another party receives an associated allocation and distribution of partnership income or gain (for instance, a management company waives the fee for the services it provides to a fund and a party related to the management company receives an interest in future partnership profits that approximates the amount of the waived fee).

Effective date

The proposed regulations purport to have a prospective effective date on or after the date the final regulations are published. However, taxpayers should exercise caution as the IRS believes that the proposed regulations generally reflect Congressional intent as to the classification of these arrangements and could be applied retroactively. The IRS is accepting comments and public hearing requests until October 21, 2015. Taxpayers, particularly private equity and hedge fund managers, should carefully review the proposed regulations.

Karl P. Fryzel, based in Locke Lord’s Boston office, is Co-Chair of the Firm's Tax Department and a member of the Private Equity & Venture Capital Group. His practice includes all aspects of tax planning for corporations, partnerships, limited liability companies and individuals engaged in business and investment activities.

Rebecca Melaas is a member of the Tax, Benefits & Compensation Department and practices in the Firm’s Boston office. Her practice includes all aspects of federal and state income taxation of corporate and flow-through entities and individuals.

Michael J. Conroy is an associate in Locke Lord’s Boston office. He is a member of the Firm’s Business Law Department as well as the Tax Department.

Locke Lord is a full-service, international law Firm of 23 offices to meet clients’ needs around the world. With a combined history of more than 125 years and a greatly enhanced domestic and global footprint, Locke Lord is a worldwide leader in the middle market sector. Locke Lord advises clients across a broad spectrum of industries including energy, insurance and reinsurance, private equity, telecommunications, technology, real estate, financial services and health care and life sciences, while providing a wealth of experience through its complex litigation, regulatory, intellectual property and fund formation teams. For more information, please visit the website at www.lockelord.com.

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